Upon its introduction back in 1974, the individual retirement account (aka IRA) revolutionized how everyone from executives to factory workers saved for their retirement. Traditional IRAs offer several advantages, including the ability to make tax-deductible contributions (using “pre-tax” income) as well as the potential to pay a lower tax rate upon withdrawal.
Twenty-three years later, in 1997, the Roth IRA was introduced. Designed for individuals who want a tax-free income source upon retirement, the Roth IRA offers several significant features that differentiate it from traditional IRAs. One of the biggest differences is that contributions made to Roth IRAs are made with “after-tax” income and are, therefore, not tax-deductible.
For investors who want greater control over their retirement income, Roth IRAs are very popular, and for good reason. But there can also be downsides. In this post, we’ll take a closer look at both the benefits and drawbacks of building your retirement nest egg using the Roth IRA.
Benefit #1: Tax-free growth and withdrawals
Because contributions to Roth IRAs are considered to already having been taxed, your contributions can grow tax-free. This is a huge benefit for many investors, as is being able to make tax-free withdrawals. With a Roth IRA, you know exactly how much money you have available because you don’t have to worry about any additional tax burden. Use CB&T’s Roth IRA Calculator to see how much you could save by retirement with a Roth IRA.
Benefit #2: Withdrawals don’t impact your adjusted gross income
A key difference between Roth IRAs and traditional IRAs is that, while qualified distributions from traditional IRAs are treated as ordinary income, distributions from Roth IRAs do not increase your adjusted gross income. This can be a big benefit if you think you might be in a higher tax bracket during retirement.
Benefit #3: No required minimum distributions (RMDs)
With a traditional IRA, you must begin making withdrawals by the time you reach the age of 72 (in fact, they are more precise than that. Withdrawals must begin by April 1 of the calendar year after age 72 is reached).
Benefit #4: Simplified estate planningWith a Roth IRA, the tax-free benefits don’t stop upon your death. Beneficiaries that inherit the account(s) can continue to enjoy tax-free growth and distributions.
Now let’s consider the downside.
Drawback #1: No initial tax benefit
Unlike a traditional IRA, contributions to Roth IRAs are made with after-tax income and are, therefore, not tax deductible. It’s the tradeoff one makes for a tax-free pool of money in retirement.
Drawback #2: Income limitations for contributions
High earners are at a disadvantage when it comes to Roth IRAs. While anyone can open a Roth account, there are limits on how much you can contribute, based on income (specifically, your modified adjusted gross income). If your income falls below the income threshold, you can contribute the full $7,000 ($8,000 if you’re 50 or older). But, if your income is higher, the amount you can contribute shrinks until it is phased out completely.
Fortunately, there is a workaround. You can open and contribute funds to a traditional IRA and then convert that account to a Roth IRA. It takes a bit of fancy footwork (and some income tax payments) but, if you’re up for it, a backdoor Roth IRA could be well worth the trouble.
If you have a traditional IRA and want to see if it makes sense for you to convert to a Roth IRA, check out CB&T’s Roth IRA Conversion Calculator.
Drawback #3: The waiting is the hardest part
While you can always withdraw your contributions at any time without incurring taxes or penalties, your earnings are another story. Those are not available for tax-free withdrawal until you a) have held the account for at least five years and b) have reached the age of 59½.
Roth IRA benefits and drawbacks at a glance
Benefits
- Tax-free growth
- Qualified distributions are tax free
- No required minimum distributions
- Beneficiaries continue to enjoy tax-free growth and qualified distributions
Drawbacks
- Contributions strictly limited based on income
- No tax deduction for contributions
- Earnings withdrawn before age 59½ (and without meeting certain criteria) can incur taxes and penalties
A final word about Roth IRAs
While Roth IRAs can be very effective way to save for retirement, it probably won’t get you across the finish line all by itself. For that you’ll probably need a well-balanced portfolio of savings accounts, including 401(k)s, traditional IRAs and other accounts. Talk to your financial planner or stop by your local CB&T branch for more information.